Rule 10b5-1 Plan Abuse Leads to Prison

For the first time, the SEC has succeeded in obtaining a judgment against a defendant in a case involving insider trading that occurred under the guise of a Rule 10b5-1 plan. The case resulted in a $17 million fine and a 42-month prison sentence.

What Are Rule 10b5-1 Plans?

Normally, individuals in possession of material nonpublic information are not allowed to trade. These individuals have an unfair advantage over other investors; the solution to this problem is to prohibit them from trading in the relevant stock until the information becomes public or is no longer material.

Company insiders, including senior executives and directors, frequently possess material nonpublic information, making it difficult for them to sell the stock they own. Rule 10b5-1 plans allow these individuals to buy or sell stock while in possession of such information by demonstrating that the decision to trade was made before they became aware of it.

As noted in the NASPP webinar “Key Trends in Executive Equity Services & Compliance,” Rule 10b5-1 plans have become an important tool in helping company insiders—who are often heavily compensated in company stock—diversify their holdings. These plans offer several advantages to both insiders and their employers:

• Generally viewed as a good governance practice and establish an affirmative defense against a charge of insider trading.
• Enable insiders to sell stock during closed trading windows and while in possession of material nonpublic information.
• Allow for better planning for insider trades, which are often subject to reporting on Forms 4 and 144, as well as other compliance procedures.
• Reduce the number of trades requiring individual pre-clearance approval.
• By eliminating the need to trade only during open window periods, 10b5-1 plans allow insiders to execute smaller trades over longer periods of time, to some extent mitigating the effect their trades might have on the company’s stock price.

Why Didn’t the Rule 10b5-1 Plan Work?

You might be wondering why the plan didn’t protect the defendant if one of its benefits is to establish an affirmative defense against insider trading. The SEC was able to successfully prosecute the defendant, Terren Scott Peizer—founder and former CEO, executive chairman, and board chair of Ontrak—by establishing that he was already in possession of material nonpublic information at the time he adopted the plan. For a 10b5-1 plan to serve as a defense, it must be adopted before the individual is in possession of such information.

Here’s a high-level overview of the facts, as presented in the SEC’s complaint

• In March 2021, Peizer learned that Ontrak might lose its largest customer, responsible for nearly 40% of Ontrak’s revenue that quarter (and later, over 50%). Ontrak had recently lost an even larger customer and was relying on this customer to make up for some of that lost revenue.
• From March until May 10, Peizer sent numerous texts and emails to Ontrak’s CEO (Peizer was no longer CEO) emphasizing the importance of retaining the customer.
• On May 4, Peizer contacted a broker about establishing a Rule 10b5-1 plan to begin liquidating his Ontrak holdings. That broker required a 14-day cooling-off period before trades could begin under the plan, so Peizer found another broker willing to implement the plan without such a delay.
• The second broker warned that a 30-day cooling-off period was standard, but Peizer chose to proceed anyway. From May 11 to July 20, 2021, he sold 596,357 shares for over $19 million. The plan certified that Peizer was “not aware of any material nonpublic information,” despite his knowledge of the potential customer loss.

But wait, there’s more:

• On May 18, the customer notified Ontrak of its intent to terminate its contract, and Ontrak’s CEO informed Peizer.
• Throughout the summer, Peizer was kept apprised of efforts to salvage the relationship and was involved in negotiations.
• On August 13—the same day Peizer learned that termination was likely—he adopted a second Rule 10b5-1 plan to sell another 463,567 shares, again without a cooling-off period and again certifying he wasn’t in possession of material nonpublic information.
• On August 18, the customer formally terminated the contract. Between August 13 and August 19, when Ontrak announced the termination, Peizer sold 45,000 shares for nearly $2 million.

The termination resulted in a 57% decrease in Ontrak’s expected 2022 revenue. From May 11, when trading began under Peizer’s first 10b5-1 plan, to August 19, when Peizer announced the termination of the contract, Peizer’s stock dropped from nearly $3,000 to about $1,000. By February 27, 2023, shortly before the SEC filed its complaint, the stock was trading at around $60. (Ontrak conducted two reverse stock splits since then; the prices stated here are adjusted for the split.)

According to the SEC, Peizer avoided more than $12 million in losses.

After a 10-day jury trial, Peizer was found guilty of one count of securities fraud and two counts of insider trading. He was sentenced to 42 months in prison and ordered to pay a $5.25 million fine and forfeit $12.7 million in ill-gotten gains.

What About New Rule 10b5-1?

Regular readers of the NASPP Blog will recall that in late 2022, the SEC amended Rule 10b5-1 to require, among other things, a cooling-off period. Peizer’s plans were implemented before these amendments took effect, which is why he was able to bypass that requirement.

Today, Rule 10b5-1 plans adopted by executives and directors must include a cooling-off period that lasts at least 90 days—or until two business days after disclosure of financial results in Form 10-Q or 10-K, whichever is later. If this rule had been in effect back in May 2021, Peizer would not have been able to trade until August—just a week or so before the contract termination was announced.

At the time, Peizer told his broker that the cooling-off period wasn’t legally required. I’m speculating here, but it’s possible that the broker and Ontrak’s compliance team (the complaint does not indicate whether the plan was reviewed internally, although this is common practice) felt pressured to proceed given Peizer’s leadership role.

Today, both could simply point to the new SEC rule. Anyone who’s had to push back on a request from an executive (or other employee) knows how helpful it is to be able to point to a rule or official pronouncement backing up your position.

More to Come?

As Liz Dunshee notes in her blog about the complaint: “Hold on to your hats, though, because there are likely more to come.” Liz says that The SEC’s Enforcement Division is actively looking for problematic Rule 10b5-1 plans and has launched a data-driven initiative to identify them.

Lessons Learned

No one wants to report that one of their executives or directors has been convicted of—much less imprisoned for—insider trading. This case underscores the importance of having a strong review and approval process for 10b5-1 plans. It may also be wise to require insiders to use a broker the company trusts to implement and manage these plans.

A memo from Jenner & Block suggests three steps to take to protect company insiders, summarized by Liz in another blog:

1. Be aware of the perils of liquidations before bad news – In-house teams should be especially vigilant when the company has hit potential setbacks that have not been disclosed, appropriately scrutinize requests to implement or change Rule 10b5-1 plans, and highlight these risks to insiders.
2. Prepare to have determinations concerning material nonpublic information second-guessed – In-house teams should document their analysis on why a certain piece of information constitutes or does not constitute inside information. Taking the time to memorialize counsels’ view on why there was no material nonpublic information preventing implementing a plan should help a company demonstrate its good faith in the event of an investigation, and avoid a perception that a company is enabling insider trading or otherwise has a weak compliance function.
3. Use training and the required certifications to highlight the importance of good faith – This is an important fact to communicate to insiders, because there are instances where the executives themselves have more information than in-house teams concerning the corporate issue at the heart of material nonpublic information analysis. To communicate the importance of the issue, in-house teams can conduct periodic trainings on insider trading. This training could also highlight to executives the rationale for the SEC’s new explicit requirement of good faith.